NEWS ANALYSIS: Churn Nightmare

Could easy access to Netflix originals undermine its business model?

Netflix next February bows two complete new seasons of original programs, including the much-anticipated BBC remake “House of Cards,” and the second season of black comedy “Lilyhammer” — both of which the subscription video-on-demand pioneer hopes will up its reputation as an evolving premium TV channel such as HBO, Showtime or AMC Networks.

The two programs are among five original series (including Fox’s “Arrested Development” renewal, women’s prison dramedy “Orange Is the New Black” and horror-thriller “Hemlock Grove”) Netflix will launch next year — shows chief content officer Ted Sarandos characterized as specifically tailored (via careful analytics) to its subscriber base.

Indeed, Netflix is firmly committed to supporting original programming, carefully cultivating media interest in “Cards,” including when the rights were acquired (reportedly beating out HBO and others), and when key cast (Oscar winner Kevin Spacey, Robin Wright) and director (Oscar winner David Fincher) were revealed.

But some analysts say this move into premium TV may be counterproductive, inviting stream-and-dashers and unwanted freeloaders, and draining Netflix’s ability to pay for its estimated $5 billion in content license liabilities.

Here’s why.

Netflix makes all episodes of its originals (and other series) available for viewing from day one. Touted as a unique value-add, the rationale is that unlike network TV, HBO, Showtime, AMC and Starz, Netflix subs don’t have to tune in weekly to catch the latest episode.

But Netflix is unlike a traditional multichannel video program distributor, which secures subscriber loyalty (and tuning in on a weekly basis) through a multiyear contract. Despite the low $7.99 monthly subscription price, Netflix subs can start and stop service on a whim without penalty. And new subs get either a 14-day or 30-day free trial when joining or re-upping (after a certain period).

Analysts say the free trial window invites abuse. For instance, a new Netflix sub could sign up for service Feb. 1, watch all 13 episodes of “Cards” and all eight episodes of “Lilyhammer”— and then cancel the service without paying a penny.

“This is a flawed approach to their business model,” said analyst Eric Wold with B. Riley & Co. in Los Angeles.

Still, Sarandos hailed binge viewing earlier this year when explaining why Netflix wouldn’t divulge viewership data for the first season of “Lilyhammer.”

“At Netflix, we are all about giving people a choice in the way they enjoy TV shows and movies,” Sarandos said. “They can watch one episode or all eight back to back. They can start in the living room on their smart TV and end in the bedroom on their iPad. We don’t show commercials so we don’t have to deliver audience numbers to advertisers. We do have to deliver a great experience to our members.”

With consumers increasingly opting for the most cost-effective home entertainment option, including kiosk rentals, allowing access to original content potentially for free represents a weak link, analysts say.

“Even if you are not eligible for the free trial, you can still watch both series in their entirety for $7.99 and then never return,” Wold said. “I understand that management is trying to get away from the mentality of having new episodes every week, but I believe that is what has proven to be effective with Showtime and HBO in getting subscribers to stick with a more expensive [monthly] service.”

Netflix co-founder and CEO Reed Hastings is adamant that binge viewing is one of the unique advantages to membership. When questioned about the potential for freeloaders during a recent fiscal call, Hastings appeared unconcerned about the few who might take advantage of the loophole if, in the long run, it helps Netflix retain the many who appreciate the exclusive content.

“We want to hook them for the long-term by treating them right and making all those episodes available at once,” Hastings said. “If we do our job right, there’s always a reason to be a Netflix member on the original side, in addition to the license side. So I don’t think that it will be material to join only for ‘House of Cards’ and then exit. That makes us comfortable with this very consumer-first trade-off.”

Some analysts think he has a point.

Analyst Rich Greenfield with BTIG Research in New York believes if a rogue binge viewer watches 13 hours of an original series, the likelihood of that person getting hooked into a subscriber is pretty high.

“You really think most people are going to sign up for Netflix to essentially bomb through a series they’ve never heard of and then just disconnect?” Greenfield said.

Michael Pachter, analyst with Wedbush Securities in Los Angeles, says Netflix and other SVOD services won’t achieve critical mass with original programming until each has at least 10 proprietary programs on tap.

He estimates that original content will provide at least 30 hours of viewing next year. And if each of the roughly 35 million domestic and international streaming subscribers views every hour of original content, the total amount of original content consumed would be about 1 billion hours.

With Netflix expected to jettison more than 10% of its content obligations next year as it attempts to rein in costs, original content will become a bigger chunk of the service’s content library.

“I believe this is a very risky and potentially costly experiment,” Wold said.